Why the backlash? Sustainable investing is simply better investing

Responsible investment is under attack. As a responsible investor supporting the transition to sustainable economies, we strive to identify and back environmental, social and governance (ESG) leaders that can protect and grow client portfolios. We have already seen signs that the global economy is starting to move to a more sustainable and equitable model over the next decade.

Still, some critics simply believe that anything ESG-related is so much greenwashing. Others argue that it is a distraction from the goal of delivering the best possible investment performance. Put differently, that investing in a responsible way limits the opportunity set and thus the potential for financial returns.

This, in our view, goes to the heart of the backlash. The evidence to support this argument is, however, inconclusive at best.

So why does the backlash, in its various forms, persist?

The shadow of 2022

Souring sentiment towards ESG can be traced back to 2022, when sustainable indices were negatively impacted by a sectoral bias amid temporarily high energy prices. Oil companies and other energy stocks performed extremely well in the wake of Russia’s invasion of Ukraine, and handed sceptics the ammunition to argue that ESG was a fad whose time had passed.

The subsequent underperformance of the energy sector in 2023 should have blunted that argument, but markets have selective memories. ESG funds have consequently yet to shrug off the stigma of 2022, despite that year’s exceptional nature and the ensuing outperformance of ESG indices.

We do not believe this situation will last. It makes little financial sense to eschew an approach whose aim is to deliver superior investment returns alongside non-financial outcomes, like mitigating climate change. But it may take several years and a deeper level of appreciation about the direction of travel at a corporate, governmental and regulatory level - ultimately the drivers of the economic case - for ESG to become as accepted as it should be.

Making the case

If short-term relative performance challenges have proved a headwind for ESG, we should also acknowledge that confusion around the topic has, to some extent, helped fuel the backlash.

What ESG is not about is over-zealous responsible investors seeking to achieve their sustainability goals using client money. What it is about in the first place is having a framework to assess a business and its operating environment across a range of key risk factors. And the evidence shows that, in the medium to long-term, businesses which are low on carbon, socially aware and display the best governance practices are likely to outperform their peers and help improve the risk profile of portfolios.

Seen through this lens, we are convinced that there can’t be any robust active investment process without a solid ESG framework. After all, when an investor is taking long-term views on companies, they must take into consideration all the risks; not just the business and market risks, but also those around potential litigation, changing consumer trends, and evolving societal attitudes and regulation towards sustainability. These are real risks, and they present real investment opportunities.

A key point here is that corporates are changing their business models themselves. Not only are they becoming more sustainable, but they are also expending significant time and resource on improving transparency across a range of issues. Most companies now produce a sustainability report because the way they do business is changing. We are not, as investors, selecting them because they are an ‘ESG’ company; but because they are attractive financial investments.

Equally, it is important to remember that corporates are not operating in a vacuum. We are in the midst of two epoch-defining transitions: the technology transition and the energy transition. These will fuel seismic shifts in the way the world economy works, and they are increasingly core to how businesses operate. If an investor is not evaluating all the risks associated with these transitions, how can they be accurately assessing a company’s ability to deliver sustainable shareholder returns?

Arguably, this point has been lost in the commotion around ESG, yet there is no doubt that the different and evolving corporate strategies adopted by asset managers has done little to impart clarity. Approaches to RI vary from highly active and committed to hands-off, with the onus on the client to decide what to do or how to vote. Some groups are increasingly attempting to straddle both camps, depending on the client-type or continent where they pitch.

This shifting spectrum has not, in some eyes, helped ESG maintain credibility when consistency is prized in a complicated area. The range of sustainable finance policies that have come into force in several geographies over recent years has further added to the complexity and confusion. It is evident that more simplicity and comparability are needed in a landscape littered with different metrics, targets and definitions.

But asset managers could be more transparent, too. Of course, they are free to choose how to engage with different policy frameworks as well as the various investor initiatives that seek to drive change through collective action. They can be more or less of a responsible investor. But they should be clearer about their choices and what approach to RI they offer and why, to allow asset owners and other investors to make informed decisions.

Where next?

As an active asset manager committed to responsible investing, we would make several observations about the future.

First, investment strategies that align with industry efforts to reduce fossil fuel usage in society are simply economically rational. Companies making aggressive cuts to their greenhouse gas emissions have been shown to at least match or outperform their wider benchmarks¹ . Corporate efforts to effect change do not have to come at the expense of shareholder returns.

Second, a huge amount of progress has already been made. Regulation, data, guidelines and benchmarks have evolved to help companies and asset managers make accurate disclosures and well-informed investment decisions. Asset managers can choose to ignore changing market frameworks. But disregarding the transition to net zero is equivalent to forfeiting the impact of the billions which governments are already spending to transform economies, support (or enforce) the decarbonisation of high emitters and assist those companies providing solutions necessary to the transition.

Third, we should not pretend that the transition is going to be painless. There is a physical and social cost to it, and that creates problems for governments. The use of renewable energy is rising in many regions as the costs rapidly decline, but the transition will have implications that have not always been acknowledged. More honesty is required.

Finally, progress will take time. While many corporates are making climate commitments and devising and implementing credible plans to meet them, it is unrealistic to expect large investors to move at the same pace. Institutional asset owners cannot transform their overall investment portfolios to meet decarbonisation commitments overnight. The practical realities of integration at that scale across asset classes should warrant patience given the challenges involved.

Will ESG still be facing the same backlash in five years’ time? We believe the answer is no. As policy prompts greater action and thus ever more investment in reducing carbon emissions, the economics of renewable energy will become increasingly compelling. It is these shifts that ESG is designed to capture to generate better investment performance over the long term. There will be blips along the way. But many of the doubts expressed about ESG miss the point. It is not about advancing agendas or foregoing returns. In today’s world, sustainable investing is a simply a better way of investing.

In a few years’ time ESG will be a redundant acronym. Assessing risk to a business, and therefore an investment, will automatically consider risks from climate change, environmental liabilities, social protection and the ongoing governance of how companies are managed. All of these factors, governed by regulation and market preferences, will constitute mainstream investment decision making. Sustainable investment returns depend on sustainable business models and that is just not about selling product but about positioning companies to prosper as the world becomes more able to quantify non-financial risks.

This article was first published in Pensions & Investments